As you may have certainly noted, Italy has been very much in our focus recently (European Reflation, Italian referendum, Europe: Running Out of Time?). This is neither to annoy nor to bore you, but an expression of our growing concerns about the diverging economic forces in the Euro Area. They could tear the common currency apart. And Italy is at the very heart of this unhealthy and deepening divergence. So, is Italy in peril?

Our main argument (we do not get tired to repeat) is the small but genuine risk of a downward spiral. The story goes as follows. As overall inflation rises, the ECB may be forced to start tightening sooner than later. Accordingly, sovereign yields begin to rise in the Euro Area. This is bad news for countries with subdued inflation such as Italy. For their real yields remain elevated although they would need lower ones to support economic growth. Against Italy’s poor record of economic performance and high debt, this might push the country over the edge at some point. What could make matters worse is that investors have an incentive to bid up sovereign yields more aggressively compared to other countries in anticipation of future economic weakness. A vicious circle.

The analysis shows that a downward spiral in Italy is still a worrisome but possible scenario, even if reality might turn out differently in the end. Dark clouds are hanging over Italy. Still, it may rain elsewhere. We will continue to monitor the development closely.

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